Good Debt vs. Bad Debt

Good debt vs. bad debt

Your personal finances are divided into two categories: good debt and bad debt. Good debt adds value to your life by building wealth or increasing your income over time. This includes debts such as student loans, mortgages, and business loans.

Bad debt refers to things like high-interest credit cards or other consumer debts that do little to improve your financial situation in the long term.

It’s important to use good debt to your advantage. Let’s look at the two most common examples of good debt – student loans and mortgages – and how they can help you to achieve your financial goals.

Student loans

A good rule of thumb is to not borrow more than what you expect to earn in the first year of your job. All education programs differ and some are more expensive than others. If you are pursuing your master’s degree in education and the starting salary is $65,000, then you should not take out more than $65,000 in loans. As your salary increases over time, that should help with your accrued interest.

Of course, you cannot predict an economic downturn upon graduation, so it is important to minimize debt earlier on. For example, COVID-19 created challenges for recent grads trying to land their first position upon graduation.

Mortgages

Mortgage debt has been considered the safest form of good debt being that each monthly mortgage payment builds equity in your home. Paying down your mortgage principal while your home appreciates will gradually shift your debt into an asset, making it a “forced savings account.” This is unlike virtually any other asset purchased with a loan, such as cars, which lose value while you pay them off.

Keep in mind that experts say to keep your monthly mortgage payment less than 28% of your gross monthly income. With today’s low interest rates and record home equity growth, a mortgage is a prime example of using debt to build wealth.

The key question

Before taking on debts, calculate your interest payments. This should help you determine if the debt is beneficial or burdensome.

Finally, ask yourself: Will this debt pay me back more than what I put in? The key is knowing what the debt does for you, and it should always be more than what you do for the debt.

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Originally published July 20, 2020, updated February 22, 2022.

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